Investment in Finished Goods Inventories: An Analysis of Adjustment Speeds

Abstract

It is well known that fluctuations in inventory investment are a major source of fluctuations in gross national product. This has stimulated numerous empirical studies designed to understand the causes of changes in inventory investment. These studies include those (for example, Michael Lovell) that utilize a flexible accelerator model of inventory behavior as well as those (for example, David Belsley) that utilize the linear decision rule approach to optimal inventory holding. The latter approach, however, can be interpreted in terms of a flexible accelerator model. See J. C. R. Rowley and P. K. Trivedi for a survey of the literature. Recently, several authors (for example, Martin Feldstein and Alan Auerbach) observed that these studies yield very implausible empirical results. The basic difficulty is that the estimates of the speed with which firms close gaps between desired and actual inventory stocks are very low. Often, the estimated speed of adjustment is less than 10 percent per quarter. As Feldstein and Auerbach stress, this is extremely implausible when even the largest swings in inventories in a given quarter amount to less than one day's production. The purpose of this paper is to undertake an analysis of adjustment speeds for finished goods inventory investment. In our empirical work, we utilize a modified flexible accelerator model of inventory investment.1 Like the conventional flexible accelerator, the model permits firms to close a fraction of the gap between desired and actual inventories in any period. The relevant fraction is of course the adjustment coefficient, and it may vary in principle between zero and unity. Our model differs from the conventional model in assuming that the desired stock of finished goods inventories depends on the normal levels of exogenous variables that firms must forecast to make decisions on inventory holdings. These include not only the normal level or orders, or demand, which is a standard explanatory variable in the empirical literature, but also the normal levels of real factor-input prices and real interest rates. In addition, we permit the normal levels to change relatively slowly in response to changes in past levels of orders, real factor-input prices, and real interest rates. Our objective is to investigate whether the slow adjustment speeds that have been estimated in the literature are due to the use of models which contain an incomplete menu of exogenous variables to determine desired inventories and pay inadequate attention to lags in the adjustment of normal levels of exogenous variables.